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Monday, April 14, 2008

Fixed Income Real Returns

Several members of my extended family invest exclusively in fixed income investments, mostly at banks. For many years now they have longed for a return to higher interest rates like they had in the 1980s.

They think that they made more money back then, but this wasn’t really the case. They may have earned more than 10% interest per year, but this doesn’t take into account taxes and inflation. To find out the real return, you need to deduct taxes and inflation. This is even more painful when you realize that you have to pay taxes on the part of the return that is eaten up by inflation.

Back in the 1980’s people felt like they were making more money, but in reality, their principal was being eroded. This misunderstanding led them to spend more than they should have.

An Example

Suppose that years ago you got 12% interest, but inflation was 7%, and your income tax rate was 40%. Then your after-tax real rate of return was 12*(1-0.4)-7=0.2%.

Suppose that today you are getting 4% interest, inflation is 2%, and your tax rate is still 40%. Then your after-tax real rate of return is 4*(1-0.4)-2=0.4%.

Even though fixed income investors might feel poorer today, their real return is actually not much different. The main difference is that they used to spend large chunks of their principal.

2 comments:

Wow... I would have thought in passing in the first case that real return was 7% before tax, and that taxes would take 40% of this to give 4.2% after tax... guess that's way off...

what I should have thought (in words) was say I had $100, then I earned $12, putting me ahead of inflation by $5, but get taxed on the inflated return of $12 * .4 = $4.80, leaving me with only 20 cents to spend! and prices have gone up!! yikes, way worse than what I would have supposed 'intuitively'.

I also notice that if taxes were not involved (most people invest in tax sheltered accounts), then in the first case, return was 7% and in the second return was 2%, reversing the conclusion (right?). I must pay more attention to taxes...